The Fatal Flaw of Obama's Mortgage Plan

Even if it works as promised, President Obama’s latest effort to aid the housing market won’t get at the root of the problem that housing poses for the economy.

SEE ALSO: Kiplinger's Housing Forecast

As before, the president is trying to spur refinancing to lower monthly payments -- in this case, targeting “underwater” borrowers who owe more than their homes are worth.

If the plan works, it would make life easier for some families, but it won’t address how the crash in home prices continues to hinder economic growth. That’s because high monthly payments aren’t the problem -- excessive debt is.

Foreclosures are the most obvious effect of the housing crisis, but the broader damage comes from the way that sinking prices have wiped out home equity, down by $7 trillion, or more than 50%. For the first time, roughly half of homeowners owe 80% or more of the value of their homes. This crushing debt has unbalanced the balance sheets and financial plans of most middle-class families, leading them to pull back on consumer spending, which accounts for 70% of economic activity.

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Even if home prices start rising again, homeowners understand that it will take years, and perhaps decades, to make a dent in this enormous debt. Until the debt burden of mortgage holders is reduced, housing will continue to depress confidence and consumer spending, as it has in Japan for 15 years.

At least three prior attempts since 2008 to assist the housing market have failed. The Obama administration said these earlier efforts would result in refinancing and lower monthly payments for 3 million to 4 million homeowners, but the total so far is only 900,000. Meanwhile, 11 million families -- nearly one in four home mortgage borrowers -- owe more than their homes are worth.

With his new proposal, the president has lowered his sights: He says he hopes to help one-tenth of the 11 million homeowners whose mortgages are underwater. It’s a new goal, but the approach is the same: waiving rules to encourage banks to refinance government-backed mortgages. Banks that agree to refinance underwater mortgages are freed from the threat that the government might later accuse them of making a loan that was too risky.

Unfortunately, the new plan shares a fatal flaw with the prior ones. It won’t work unless homes promptly start rising in value, which isn’t in the cards. By some measures, home prices would still have to fall 10% to revert to the long-term price trend before the bubble. And after falling a bit, the number of homes headed for foreclosure is increasing again. The economy isn’t adding jobs, incomes are falling, and most forecasts are for another year of very slow growth.

Many borrowers with underwater mortgages are defaulting in part because they see no prospect of a return on further investment. Until these borrowers and others are convinced that homes are a good investment, no government program will be able to boost the housing market.

The only effective solution to the problem is an unlikely one: an expensive, government-led plan to write off the debts of those with no equity. It would be unpopular because it would rescue many borrowers who took on homes they couldn’t afford, even if the effects promise to raise everyone’s home values. Government would share the cost with banks, which would have to be persuaded or forced to write off debt. A plan advocated by Harvard economist Martin Feldstein would lower the debts of underwater homeowners to no more than 110% of the home’s value -- within hailing distance of positive equity. The out-of-pocket expense for the government would be $350 billion, but a good chunk of that is already committed because millions of these loans are insured by government-owned Fannie Mae and Freddie Mac, and thus Uncle Sam is on the hook.

It’s hard to imagine Republicans and Democrats joining together for something like this. But absent such radical action, housing will hobble the economy for years to come.

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